Monetary policy, not interest rate cuts, is the key to the efficient, equitable deployment of the stimulus package
By Andy Xie, board member of Rosetta Stone Advisors Limited, Caijing 9 December 2008
The market received positively China’s announcement of 4 trillion yuan fiscal stimulus. This impetus, together with the Obama Administration’s plans for a big fiscal stimulus, possibly over US$ 500 billion, sent the market bounding on the hope of economic recovery.
From its recent Nov 20 nadir, the S&P 500 jumped 19 percent, while the Hang Seng Index rose 15 percent within seven trading sessions. Optimism about China and the United States’ fiscal stimuli played a major role in the market recovery. Interest rate cuts and the bailout of the Citigroup were of secondary importance. In a credit crisis, fiscal stimulus is far more effective than cutting interest rates.
Cutting interest rates works by encouraging borrowing. Liquidity is a euphemism for short-term debt. Greenspan’s rate decisions changed debt demand for asset speculation. Through its impact on asset prices he moved the economy. Economic theory says that monetary policy works through changing demand for debt in the real economy. Asset prices move with monetary policy in anticipation of the change to future economic activities. The magnitude of such asset price movement wouldn’t be big enough to affect economic activities.
When the magnitude of asset price change in response to monetary policy is big enough to determine economic activities, it is a bubble. I have made this point numerous times in the past 10 years to emphasize that Greenspan’s magic was a bubble. For the diehard Greenspan worshippers out there, wake up and smell the coffee!
When a credit bubble bursts, cutting interest rate is a stabilizing force. It decreases the interest payment for debtors and the incidence of bankruptcies. However, it couldn’t recharge economic activities through increasing debt demand. A far better approach is to print money and distribute it evenly among people. When a credit bubble bursts, debtors need a write-off. It can be done through bankruptcy or inflation. Distributing printed money evenly among people causes the least distortion to achieve a general debt reduction through inflation.
U.S. households have too much debt compared to their income. They need a write-off now and to spend less in the future. If the Fed prints US$ 30 thousand per capita and distributes it to everyone American citizen, it would total US$ 9 trillion versus US$14 trillion of household debt. Some households don’t have debts and can hang onto the money. Others will pay down their mortgages or credit card debts.
Of course, there will be inflation and dollar depreciation. As long as the printing is done in a transparent fashion, there shouldn’t be overshooting. The U.S. real economy has about US$ 34 trillion in debt. If the Fed prints US$ 9 trillion, the general price level should rise by 26 percent and the dollar down by 21 percent. Both would be reasonable prices to pay for solving the problems.
The current monetary policy is (1) cutting interest rate to help debtors stay alive, and (2) bailing out failing financial institutions and other businesses with capital injections and debt guarantees. The Fed has committed US$ 8 trillion for the later. These approaches don’t solve problems and reward bad companies. They decrease economic efficiency, and causes unpredictable inflation in future. Keeping interest rate so low may revive commodity speculation, causing great harm to a weak economy. The Fed should rethink its policy.
Cutting interest rates in China has a more negative impact than in the US. It is totally false to claim that lowering interest rates would boost consumption. It may decrease incentives for saving, as returns on bank deposits decline, and boost debt demand for financing consumption. But the former is offset by the negative income effect from lowering interest rate. The later is minimal in China. Chinese consumer credit is virtually non-existent. It is wishful thinking to hope for this effect by cutting interest rates.
China’s interest rates are about dividing benefits among borrowers, banks, and savers, not about boosting or cooling the economy. For the past 10 years, the interest rate policy has shorted savers in favor of banks and borrowers. The deposit rates have been kept at one-third of the growth rate of nominal GDP. This is the root cause for so many bubbles in China. When interest rates are so low compared to economic growth, savers become credulous about all sorts of quick money schemes. From stocks and properties to puer tea and modern paintings, bubbles have happened big and small, doing great damages to the Chinese economy and society.
Naïve first-time investors have lost their savings. Many people who speculated in the market saw their portfolios fluctuate more in a day than they earn in a month. These people have lost their desire to hang onto their jobs. The market burst may not bring them back to their previous occupations.
Numerous cities have become hooked onto the money from property development. They were building properties like a factory manufactures TV sets, assuming the properties would sell at antique prices. Banks lent trillions to developers for property construction before the properties could be sold. These bank loans became local government revenues. In a bubble, who cares, as long as someone else would pay a higher price down the road.
The low interest rate caused the problems that are haunting us. Now, governments say the solution is further lowering interest rates. Somehow, this doesn’t sound right.
Conventional wisdom says that a central bank should cut interest rates when the economy goes down. That is true in a conventional downturn driven by inventory cycle. After a credit bubble bursts, cutting interest rates has much less punch. A better approach is to print money and distribute among people to cause inflation that decreases the general debt burden, while keeping interest rate relatively high.
China is facing three headwinds in its economy. First and foremost, declining global demand is cutting China’s exports. Second, stock market bursting is dampening luxury consumption demand, especially for big ticket items like automobiles. Third, the property sector is experiencing a huge inventory overhang, which decreases new property development.
There aren’t many measures to deal with the first two negative factors. The Chinese government has already increased value-added tax rebates for exporters. Policy in the current environment should enhance survivability and prevent unnecessary bankruptcies. Their revenues would only recover with the global economy. The negative effect on luxury consumption from the stock market cannot be reversed. The market was a bubble. The strong luxury demand was unsustainable anyway. Besides, luxury prices in China are much higher than in other and richer countries. It was a bubble phenomenon. I saw something similar in Southeast Asia 10 years ago. The market needs to normalize. Weak demand is forcing the issue.
There are effective policies to deal with the property inventory. The U.S. property market has absolute oversupply. Many households were buying second homes purely for speculation. When the bubble bursts, there are just too many houses against the number of households. Most Chinese urban households still live in old and low quality flats. They would prefer the new flats. But the price level, around 20 times household income in many cities, makes purchase impossible. If the prices come down, the flats could be sold. I have suggested tax reductions – e.g., decreasing transaction taxes and making purchase deductible from income tax – to clear the inventory.
Cutting interest rates won’t clear the inventory. The affordability is too low for interest rate to make a big difference. If monetary policy is to be used for clearing the property inventory, it would be better to print money and distribute it evenly among people. For example, the central bank could print 20 thousand yuan per capita. This would give poor households the money for down payment, bringing a new buyer group. Of course, it would lead to inflation, which decreases property price in real terms. As long as the monetary expansion is transparent, it won’t lead to hyperinflation and would be good for social harmony.
Maybe China and the U.S. should coordinate monetization. The pair can print similar amounts of money relative to their GDP and keep their currencies linked up. It would decrease exchange rate volatility during monetization. After a credit bubble bursts, economic revival depends on a debt write-off. Cutting interest rate doesn’t achieve that. A better approach is to print the necessary amount of money.
Fiscal stimulus is certainly effective in the current environment. The credit market is not functioning effectively as declining asset prices have made the capital base of borrowers too thin. As discussed above, debt reduction through inflation could revive the credit market. An alternative is for fiscal stimulus to boost their income. Overtime, their capital base improves. This is a slow approach and may require massive buildup of public debt. Japan adopted this approach in the early 1990s. Its national debt has surpassed 160 percent of GDP, and yet, its economy is still sluggish.
China’s new fiscal package is not all new money. Only the increase against the old spending plan is the stimulus part. It is too early to tell the exact amount. The change in the fiscal position of the central government, especially in regard to the issuance of government bonds, should be noted. Bank financing plays a big part in infrastructure projects. Increasing investment here should have a bigger effect because of this. If the central government issues 500 billion yuan in treasury bonds, which in turn leads to 500 billion yuan of bank financing for related projects, the total amount of stimulus is about 1 trillion yuan. I suspect the total stimulus will be close to that next year.
China must keep an eye on two risks associated with fiscal stimulus. First, low efficiency projects could be funded with little long-term benefit. There are indications that wasteful spending could be coming. Reportedly, local government representatives were lining up at the National Development and Reform Commission (NDRC) for handouts. Projects that were shot down by the NDRC were brought back. The tendency is to spread the projects around to make all happy. This is not optimal. Most places in China should not urbanize or industrialize. Their ecosystem is too fragile, and their local population will migrate eventually.
China is a poor country. The money for fiscal stimulus should be used carefully to promote the country’s long-term development. Urbanization is probably the most important part of the development process. As I have written for the past decade, China must concentrate its resources to build super cities. China’s population is 4.3 times that of the U.S., with half as much habitable land. With everything else staying constant, China’s cities should be 8.6 times as big as their American counterparts. It may sound frightening, but it makes a lot of sense. Most would understand that urbanization has huge economies of scale in infrastructure development. Less understood are the economies of scale in job creation. By allowing greater division of labor, large cities offer more job opportunities than small cities.
Local governments issuing bonds has become a hot topic. It would be a disaster to allow it at present. It would lead to wasteful spending and local government bankruptcy. Ultimately, the central government would be liable for local government debt. It is much better for the central government to issue bonds and distribute the money to local governments. It could be part of fiscal reform. For example, the share of fiscal revenue for local governments could be boosted by five percentage points and be applicable retroactively for 3 to 5 years. The central government could issue bonds to fund the cost. It alleviates the fiscal crisis at local government level, put their fiscal position at a more solid ground in the future, and contains the risk of local government bankruptcies.
The right to issue bonds must be tied to China’s urbanization strategy. Only successful cities would be able to repay their debts. Before the grand strategy is clear, the local bond markets shouldn’t develop.
It may serve China better to spend its fiscal stimulus money on unemployment benefits. The economic downturn may cause 20 million migrant workers to lose jobs.
Infrastructure projects could absorb some. But it would take time for all of them to be employed. The Chinese government should consider allocating some stimulus money to help them through this period.
Five hundred yuan per person or 10 billion yuan per month could alleviate their difficulties, I believe. This amount is relatively small compared to the stimulus package and would be an effective support for social stability during the economic downturn.
Some local governments are issuing policies to restrict layoffs at businesses. This would be wrong. Chinese companies need to upgrade to generate another growth cycle. And they can’t do this without being able to restructure their labor force. If companies are forced to keep excess labor, the business sector will decline in efficiency, and the whole country would suffer. Companies should be allowed to restructure to achieve maximum efficiency. Governments should use fiscal levers to help the affected workers.
China’s macro policy has shifted to a simulating stance. The stimulus should be deployed in the most efficient and equitable manner. We are still in the early days of the stimulus policy. Care must be taken to fill in the details.
1 comment:
On Effective Stimulus
Monetary policy, not interest rate cuts, is the key to the efficient, equitable deployment of the stimulus package
By Andy Xie, board member of Rosetta Stone Advisors Limited, Caijing
9 December 2008
The market received positively China’s announcement of 4 trillion yuan fiscal stimulus. This impetus, together with the Obama Administration’s plans for a big fiscal stimulus, possibly over US$ 500 billion, sent the market bounding on the hope of economic recovery.
From its recent Nov 20 nadir, the S&P 500 jumped 19 percent, while the Hang Seng Index rose 15 percent within seven trading sessions. Optimism about China and the United States’ fiscal stimuli played a major role in the market recovery. Interest rate cuts and the bailout of the Citigroup were of secondary importance. In a credit crisis, fiscal stimulus is far more effective than cutting interest rates.
Cutting interest rates works by encouraging borrowing. Liquidity is a euphemism for short-term debt. Greenspan’s rate decisions changed debt demand for asset speculation. Through its impact on asset prices he moved the economy. Economic theory says that monetary policy works through changing demand for debt in the real economy. Asset prices move with monetary policy in anticipation of the change to future economic activities. The magnitude of such asset price movement wouldn’t be big enough to affect economic activities.
When the magnitude of asset price change in response to monetary policy is big enough to determine economic activities, it is a bubble. I have made this point numerous times in the past 10 years to emphasize that Greenspan’s magic was a bubble. For the diehard Greenspan worshippers out there, wake up and smell the coffee!
When a credit bubble bursts, cutting interest rate is a stabilizing force. It decreases the interest payment for debtors and the incidence of bankruptcies. However, it couldn’t recharge economic activities through increasing debt demand. A far better approach is to print money and distribute it evenly among people. When a credit bubble bursts, debtors need a write-off. It can be done through bankruptcy or inflation. Distributing printed money evenly among people causes the least distortion to achieve a general debt reduction through inflation.
U.S. households have too much debt compared to their income. They need a write-off now and to spend less in the future. If the Fed prints US$ 30 thousand per capita and distributes it to everyone American citizen, it would total US$ 9 trillion versus US$14 trillion of household debt. Some households don’t have debts and can hang onto the money. Others will pay down their mortgages or credit card debts.
Of course, there will be inflation and dollar depreciation. As long as the printing is done in a transparent fashion, there shouldn’t be overshooting. The U.S. real economy has about US$ 34 trillion in debt. If the Fed prints US$ 9 trillion, the general price level should rise by 26 percent and the dollar down by 21 percent. Both would be reasonable prices to pay for solving the problems.
The current monetary policy is (1) cutting interest rate to help debtors stay alive, and (2) bailing out failing financial institutions and other businesses with capital injections and debt guarantees. The Fed has committed US$ 8 trillion for the later. These approaches don’t solve problems and reward bad companies. They decrease economic efficiency, and causes unpredictable inflation in future. Keeping interest rate so low may revive commodity speculation, causing great harm to a weak economy. The Fed should rethink its policy.
Cutting interest rates in China has a more negative impact than in the US. It is totally false to claim that lowering interest rates would boost consumption. It may decrease incentives for saving, as returns on bank deposits decline, and boost debt demand for financing consumption. But the former is offset by the negative income effect from lowering interest rate. The later is minimal in China. Chinese consumer credit is virtually non-existent. It is wishful thinking to hope for this effect by cutting interest rates.
China’s interest rates are about dividing benefits among borrowers, banks, and savers, not about boosting or cooling the economy. For the past 10 years, the interest rate policy has shorted savers in favor of banks and borrowers. The deposit rates have been kept at one-third of the growth rate of nominal GDP. This is the root cause for so many bubbles in China. When interest rates are so low compared to economic growth, savers become credulous about all sorts of quick money schemes. From stocks and properties to puer tea and modern paintings, bubbles have happened big and small, doing great damages to the Chinese economy and society.
Naïve first-time investors have lost their savings. Many people who speculated in the market saw their portfolios fluctuate more in a day than they earn in a month. These people have lost their desire to hang onto their jobs. The market burst may not bring them back to their previous occupations.
Numerous cities have become hooked onto the money from property development. They were building properties like a factory manufactures TV sets, assuming the properties would sell at antique prices. Banks lent trillions to developers for property construction before the properties could be sold. These bank loans became local government revenues. In a bubble, who cares, as long as someone else would pay a higher price down the road.
The low interest rate caused the problems that are haunting us. Now, governments say the solution is further lowering interest rates. Somehow, this doesn’t sound right.
Conventional wisdom says that a central bank should cut interest rates when the economy goes down. That is true in a conventional downturn driven by inventory cycle. After a credit bubble bursts, cutting interest rates has much less punch. A better approach is to print money and distribute among people to cause inflation that decreases the general debt burden, while keeping interest rate relatively high.
China is facing three headwinds in its economy. First and foremost, declining global demand is cutting China’s exports. Second, stock market bursting is dampening luxury consumption demand, especially for big ticket items like automobiles. Third, the property sector is experiencing a huge inventory overhang, which decreases new property development.
There aren’t many measures to deal with the first two negative factors. The Chinese government has already increased value-added tax rebates for exporters. Policy in the current environment should enhance survivability and prevent unnecessary bankruptcies. Their revenues would only recover with the global economy. The negative effect on luxury consumption from the stock market cannot be reversed. The market was a bubble. The strong luxury demand was unsustainable anyway. Besides, luxury prices in China are much higher than in other and richer countries. It was a bubble phenomenon. I saw something similar in Southeast Asia 10 years ago. The market needs to normalize. Weak demand is forcing the issue.
There are effective policies to deal with the property inventory. The U.S. property market has absolute oversupply. Many households were buying second homes purely for speculation. When the bubble bursts, there are just too many houses against the number of households. Most Chinese urban households still live in old and low quality flats. They would prefer the new flats. But the price level, around 20 times household income in many cities, makes purchase impossible. If the prices come down, the flats could be sold. I have suggested tax reductions – e.g., decreasing transaction taxes and making purchase deductible from income tax – to clear the inventory.
Cutting interest rates won’t clear the inventory. The affordability is too low for interest rate to make a big difference. If monetary policy is to be used for clearing the property inventory, it would be better to print money and distribute it evenly among people. For example, the central bank could print 20 thousand yuan per capita. This would give poor households the money for down payment, bringing a new buyer group. Of course, it would lead to inflation, which decreases property price in real terms. As long as the monetary expansion is transparent, it won’t lead to hyperinflation and would be good for social harmony.
Maybe China and the U.S. should coordinate monetization. The pair can print similar amounts of money relative to their GDP and keep their currencies linked up. It would decrease exchange rate volatility during monetization. After a credit bubble bursts, economic revival depends on a debt write-off. Cutting interest rate doesn’t achieve that. A better approach is to print the necessary amount of money.
Fiscal stimulus is certainly effective in the current environment. The credit market is not functioning effectively as declining asset prices have made the capital base of borrowers too thin. As discussed above, debt reduction through inflation could revive the credit market. An alternative is for fiscal stimulus to boost their income. Overtime, their capital base improves. This is a slow approach and may require massive buildup of public debt. Japan adopted this approach in the early 1990s. Its national debt has surpassed 160 percent of GDP, and yet, its economy is still sluggish.
China’s new fiscal package is not all new money. Only the increase against the old spending plan is the stimulus part. It is too early to tell the exact amount. The change in the fiscal position of the central government, especially in regard to the issuance of government bonds, should be noted. Bank financing plays a big part in infrastructure projects. Increasing investment here should have a bigger effect because of this. If the central government issues 500 billion yuan in treasury bonds, which in turn leads to 500 billion yuan of bank financing for related projects, the total amount of stimulus is about 1 trillion yuan. I suspect the total stimulus will be close to that next year.
China must keep an eye on two risks associated with fiscal stimulus. First, low efficiency projects could be funded with little long-term benefit. There are indications that wasteful spending could be coming. Reportedly, local government representatives were lining up at the National Development and Reform Commission (NDRC) for handouts. Projects that were shot down by the NDRC were brought back. The tendency is to spread the projects around to make all happy. This is not optimal. Most places in China should not urbanize or industrialize. Their ecosystem is too fragile, and their local population will migrate eventually.
China is a poor country. The money for fiscal stimulus should be used carefully to promote the country’s long-term development. Urbanization is probably the most important part of the development process. As I have written for the past decade, China must concentrate its resources to build super cities. China’s population is 4.3 times that of the U.S., with half as much habitable land. With everything else staying constant, China’s cities should be 8.6 times as big as their American counterparts. It may sound frightening, but it makes a lot of sense. Most would understand that urbanization has huge economies of scale in infrastructure development. Less understood are the economies of scale in job creation. By allowing greater division of labor, large cities offer more job opportunities than small cities.
Local governments issuing bonds has become a hot topic. It would be a disaster to allow it at present. It would lead to wasteful spending and local government bankruptcy. Ultimately, the central government would be liable for local government debt. It is much better for the central government to issue bonds and distribute the money to local governments. It could be part of fiscal reform. For example, the share of fiscal revenue for local governments could be boosted by five percentage points and be applicable retroactively for 3 to 5 years. The central government could issue bonds to fund the cost. It alleviates the fiscal crisis at local government level, put their fiscal position at a more solid ground in the future, and contains the risk of local government bankruptcies.
The right to issue bonds must be tied to China’s urbanization strategy. Only successful cities would be able to repay their debts. Before the grand strategy is clear, the local bond markets shouldn’t develop.
It may serve China better to spend its fiscal stimulus money on unemployment benefits. The economic downturn may cause 20 million migrant workers to lose jobs.
Infrastructure projects could absorb some. But it would take time for all of them to be employed. The Chinese government should consider allocating some stimulus money to help them through this period.
Five hundred yuan per person or 10 billion yuan per month could alleviate their difficulties, I believe. This amount is relatively small compared to the stimulus package and would be an effective support for social stability during the economic downturn.
Some local governments are issuing policies to restrict layoffs at businesses. This would be wrong. Chinese companies need to upgrade to generate another growth cycle. And they can’t do this without being able to restructure their labor force. If companies are forced to keep excess labor, the business sector will decline in efficiency, and the whole country would suffer. Companies should be allowed to restructure to achieve maximum efficiency. Governments should use fiscal levers to help the affected workers.
China’s macro policy has shifted to a simulating stance. The stimulus should be deployed in the most efficient and equitable manner. We are still in the early days of the stimulus policy. Care must be taken to fill in the details.
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